1 / 28

Real Options in Capital Budgeting

Real Options in Capital Budgeting. Capital Budgeting. Value of Follow-on Opportunities Gaining a foothold so that future projects are possible Value of Waiting Abandonment Options. Follow-on Opportunities.

wilton
Download Presentation

Real Options in Capital Budgeting

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Real Optionsin Capital Budgeting

  2. Capital Budgeting • Value of Follow-on Opportunities • Gaining a foothold so that future projects are possible • Value of Waiting • Abandonment Options

  3. Follow-on Opportunities • Suppose your firm is evaluating the Lev-I, a personal levitation transport device. The cash flows are shown on the next slide • They are extremely simplified, but that is not important to what we are illustrating

  4. Lev-I Project Cash Flows

  5. Why We Might Accept • We want to preempt the competition from entering the PLTD market which we believe will be highly profitable in the long run • The Lev-I might teach us things that will be useful for developing the next generation Lev-II

  6. Lev-II Cashflows

  7. Proceed? • The Lev-II doesn’t look any better • The NPV is twice as bad as the Lev-I • This business does not look promising!

  8. The Lev-II as an Option • Undertaking the Lev-I gives us an option to do the Lev-II, which will not be available without the Lev-I • Can we value the option?

  9. Call Option Valuation

  10. Option Valuation Parameters

  11. Option Valuation

  12. Re-evaluating the Lev-I • The DCF valuation of the Lev-I was (205.63) • The Lev-II option is worth 305.30 • With the Lev-II option, the Lev-I is worth 99.67 > 0, accept

  13. How Can It Be So Valuable? • The option valuation only considers those outcomes that will result in positive NPVs for the Lev-II • If we get to 2008 and find the expected cash flows are better than we anticipated, we will proceed with the Lev-II • Otherwise, we do not proceed

  14. Cautionary Note • Option theory can be used to justify very optimistic valuations • What happens is all of the firm’s projects are accepted based on the value of options and none of the options expire in the money?

  15. Value of Waiting • You have a claim that will allow your firm to obtain a 100% interest in an oil well by simply investing the $10 million needed to develop the well • If development has not begun by next year, the claim will expire and revert back to the government

  16. Value of Waiting • Currently, you forecast annual perpetual cash flows of $1.1 million • The discount rate is 10% • NPV = 1.1MM/10% - $10MM = $1MM • This is positive, so you could proceed immediately

  17. Price Uncertainty • Suppose that the price of oil is volatile • If the price of oil next year falls, the expected perpetual annual cash flows would be $0.8MM, resulting in a project NPV of ($2MM) • If the price rises, these cash flows will rise to $1.4MM, resulting in a project NPV of $4MM

  18. First Year Returns • Low Price: • (0.8MM + 8.0MM)/$10MM = -12% • High Price • (1.4MM + 14MM)/$10MM = 54%

  19. Risk Neutral Expected Return • Assume an risk free rate of 10% • Let pH be the probability of high price • The probability of low price is (1- pH) E(r) =(-12%)(1-pH)+54%(pH) = 10% pH = 1/3

  20. Option to Wait • If you wait until next year, what is the well be worth today? • [(1/3)x4MM + (2/3)(0)]/(1.1) = $1.21MM, compared to the $1MM is developed now

  21. Why Is Waiting Valuable? • The passage of time resolves uncertainty • If a year from now, the conditions deteriorate, we can decide not to invest in a bad project • We are cutting of some of the left tail of the distribution

  22. Abandonment Option • We can invest $12MM in a project that will generate gross margin of $1.7MM annually. This margin is expected to grow at 9% annually Fixed costs are $0.7MM annually and will not grow.

  23. DCF Analysis

  24. Abandonment • Ignored in the previous example is the fact that there are many possible outcomes or paths where it may be better to stop the project and collect the project salvage values. • Suppose that $10MM of the $12MM project cost is for fixed assets that have a salvage value that declines at 10% annually.

  25. Building a Binomial Tree • Suppose that historically prices have evolved according to a random walk with a s = 14%

  26. Risk Neutral Expected Return • With a risk free rate of 6% • Let pH be the probability of high price • The probability of low price is (1- pH) E(r) =(-13%)(1-pH)+15%(pH) = 6% pH = 0.6791 • Note, there is a minor rounding error in the source example

  27. Binomial Tree • See the spreadsheet

  28. Discussion • Again, the value is created by the flexibility of being able to eliminate the unfavourable results or branches

More Related